27 October 2010

Federal Reserve policymakers must be pleased with themselves. Market participants have fallen in line like lemmings off a cliff pursuing the obvious trades as the excitement over quantitative easing builds. Equities, bonds, commodities are all up. Dollar is down. Perhaps more importantly, measured inflation expectations have trended higher. Psychology is a powerful thing. Like leverage. ... (keep reading).

The Federal Reserve is close to embarking on another round of monetary stimulus next week, against the backdrop of a weak economy and low inflation—and despite doubts about the wisdom and efficacy of the policy among economists and some of the Fed's own decision makers. (Keep reading.)

The biggest U.S. banks virtually doubled their collective earnings in the third quarter just by injecting $8.1 billion into net income from funds they had set aside to cover loan losses.

There are 18 commercial banks in the U.S. with at least $50 billion in assets, and together they earned an adjusted $16.8 billion in the third quarter. Of those profits, nearly half, or 48%, were from drawing down what bankers call loan-loss reserves, according to an analysis by Dow Jones Newswires. A year ago, the same 18 banks earned $6.2 billion in quarterly profits; at that time, they added more than $7.8 billion to the same reserves, a move that reduced their profits. The analysis omits a $10.4 billion noncash charge to earnings that Bank of America Corp. disclosed during the third quarter. (Keep reading.)

Although this appears to be the first time that newly issued TIPS have locked in a negative real return, that's because TIPS have only been offered to U.S. investors since 1997. You can get a longer time series by comparing the yield on a 6-month T-bill at any date with what the CPI inflation rate actually turned out to be over the subsequent 6 months for which investors held that bill, a magnitude sometimes described as the "ex-post real interest rate." That series is plotted below. We've actually been in a period for several years in which short-term loans to the government were a losing proposition in real terms, and the longer-term real yields such as the 5-year TIPS are only now coming down to join them. The recent era of negative real yields was briefly (if spectacularly) interrupted in the fall of 2008, when a sharp deflation in the CPI made short-term loans to the government an excellent deal for the lender in ex-post real terms.

Negative ex-post real rates on short-term securities are thus nothing new. We saw them for much of this decade and for much of the 1970s. Although negative realized ex-post real rates do not establish that investors knew that they were in for a losing bargain in real terms, they persisted long enough in the 1970s that it's hard to believe that people were shocked by the continually repeated outcome. I think if TIPS had been offered at that time, we would have seen a negative real yield then, too.

Even so, within those models, there's an incentive to buy and hold those goods that are storable. And in terms of the historical experience, episodes of negative real interest rates have usually been associated with rapidly rising commodity prices.

Higher commodity prices will hurt the recovery only if they rise in real terms. And they’ll only rise in real terms if QE succeeds in increasing real demand. And this will happen only if, yes, QE2 is successful in helping economic recovery.

What this official is saying is a version of the classic freshman mistake: an increase in demand leads to higher prices, and higher prices make people buy less, so an increase in demand leads to lower sales.

Somehow I can't find Geithner's letter to G20 ministers on the Treasury Web site, so here's the WSJ link ($) to it. And while I'm at it, here's a link to the full G20 communiqué that came out of this weekend's summit.

Tomorrow I'll react to both: What do they mean for Mexico? For markets?

09 October 2010

What is not evident, however, is how much further that debt now needs to decline to produce any sense of normality. We do not know, in other words, how far along we are into this “deleveraging” process, nor what this might mean for growth or asset prices.

The current data on the issue looks mixed. In some respects – and in some sectors – there might seem to be reason for cheer. The latest capital markets monitor from the Institute of International Finance, published this week, reports a “sharp decline in the liabilities of the US shadow banking system this year”, amid “ongoing deleveraging – in particular by US households”.

Total liabilities of the shadow banks have dropped from almost $22,000bn two years ago, to nearer $17,000bn, or where it was five years ago. “Debt levels for US households, businesses and particularly financial institutions continue to decline” the IIF notes, as a proportion of gross domestic product, towards levels seen earlier in the last decade.

A separate recent report from Citi’s European credit team reinforces that point. This data also suggests that a sharp deleveraging has already occurred for banks. And in the non-banking corporate world, net debt to ebitda for S&P non financials is now running at around 140 per cent, down from 210 per cent at the peak in late 2008. For the EuroStoxx non-financials, the ratio has moved from around 230 per cent to 170 per cent.

If the pattern seen in earlier economic cycles were to play out, investors should welcome this news. With debt levels suitably reduced, banks and companies should now feel confident enough to start borrowing again – and thus raising investment, spending and so on. But that does not appear to be occurring: after cutting debt, companies are still (for the most part) sitting on vast piles of cash; so, it seems are households. Meanwhile banks are resolutely refusing to make large volumes of new loans.

Why? One reason may be that the household sector is still running a big debt burden by historical standards, and is beset by unemployment. Another is that regulatory uncertainty is sapping corporate nerves. However, the Citi team thinks the biggest issue is that rising public sector debt is undermining confidence too, or creating a climate of “fear”, as Alan Greenspan wrote in the FT yesterday. Most notably, even as the private sector has delivered, public debt has exploded.

Termina en una nota pesimista:

Thus the total scale of leverage in the system – namely the sum of both non-financial public and private debt – has not fallen markedly in the last two years (in America, for example, it is now running at around 220 per cent, compared to 170 per cent at the start of the decade.). Hence, Citi argues, investors cannot expect a “normal cycle”; companies and consumers alike are too shell-shocked by the recent past – and so uncertain about how governments will deal with all that public debt in the future. The most likely path for the next few years therefore is one of sluggish growth at best.